News broke on February 15th that the SEC is considering a proposal that would remove § 275.206(4)-2 (the “Custody Rule”) and replace it with § 275.223-1 (the “Safeguarding Rule”). The goal of the Safeguarding Rule is to not only enhance protections for investors, but also provide an evergreen definition of “assets” that will encompass new investment types as they continue to evolve. In some cases, the Safeguarding Rule merely formalizes best practices, like requiring language already present in most custodial agreements, but in other cases expands beyond just custody rule, in some notable ways discussed below.
The Silver Compliance team has reviewed the proposed rule and noted the following key takeaways that SEC-registered investment advisers should know:
- The Safeguarding Rule would expand beyond the requirements of the Custody Rule to cover all asset classes – it extends the types of investments that an adviser must custody with a qualified custodian beyond client “funds and securities” to client “assets.” This wider range of investments would include crypto assets, physical assets like real estate or artwork, and other financial contracts held for investment purposes.
- The Safeguarding Rule requires advisers to properly segregate investors’ assets and obtain reasonable assurances from qualified custodians that they do the same to protect investor assets in the event of insolvency or bankruptcy – it requires advisers with custody of client assets to segregate those assets by (1) titling or registering the assets in the client’s name or otherwise holding the assets for the client’s benefit, (2) not commingling the assets with the adviser’s or any of its related persons’ assets, and (3) not subjecting the assets to any right, charge, security interest, lien, or claim of any kind in favor of the investment adviser or its related persons or creditors. This provision applies regardless of whether client assets are maintained by a qualified custodian. Further, though the Custody Rule already mandates that advisors and qualified custodians segregate clients’ funds and securities, as discussed above, the Safeguarding Rule broadens these protections to cover all types of assets.
- The proposed rule would also explicitly include discretionary authority to trade within the definition of custody – it generally preserves the current definition of “custody” but explicitly includes discretionary authority as an arrangement that triggers the Rule. This means that when an adviser has discretionary authority over a client’s assets, the Safeguarding Rule would apply even if the adviser doesn’t physically hold the assets to ensure those assets are properly safeguarded.
- Regardless of what form the finalized Safeguarding Rule takes, it will almost certainly entail additional recordkeeping requirements and disclosures on Form ADV – it updates and enhances recordkeeping requirements for advisers, in alignment with the provisions of the Safeguarding Rule. The Safeguarding Rule also modifies Form ADV to harmonize reporting requirements with the proposal and enhance the precision of custody-related information accessible to the Commission, the staff, and the general public.
It is very important that private fund managers bear in mind that the finalized Safeguarding Rule could differ substantially from the proposal, and compliance will not be required until mid-2024, at the earliest.
Additionally, it is also imperative to understand that while the Safeguarding Rule represents the first and most meaningful example of SEC rulemaking that applies directly and explicitly to both crypto assets, and investment advisers managing crypto assets, it is unlikely that this signals a pivot away from rulemaking through enforcement action. Nonetheless, there are several important takeaways for crypto asset managers:
- Most crypto assets are likely to be funds or asset securities covered by the Custody Rule.
- Though some crypto platforms may claim to custody investors’ crypto, investment advisers cannot rely on them as qualified custodians, as these platforms often commingle investors’ assets with their own and other investors’ crypto, leaving investors vulnerable to bankruptcy. Accordingly, trading crypto assets on platforms that are not qualified custodians would result in a violation of both the Custody Rule and the Proposed Rule.
- Advisers that maintain their client’s crypto assets themselves or take the position that crypto assets are not covered by the Custody Rule are not compliant with the rule.
- The Safeguarding Rule expand Custody Rule’s coverage to include all crypto assets, including those that currently are covered as funds and securities and those that may not be funds or securities, such as NFTs.
The Silver team will continue to monitor the full impact of this proposed rule change on private fund managers, particularly those that utilize digital assets in their investment strategy, as the Safeguarding Rule works its way through the 60-day comment period and will provide updates as new developments take shape. In the interim, don’t hesitate to contact a member of Silver’s Compliance team with questions on these proposed changes and the ways we can help to ensure your firm’s compliance program remains on track and aligned with the SEC’s latest rule enhancements.